Recently, the Wealthy Boomer discussed the investment ideas of Zvi Bodie, a Boston University finance professor (the web page with this article has disappeared since the time of writing). Bodie advocates investing 100% of assets in inflation-protected bonds called Real Return Bonds in Canada and TIPS (Treasury Inflation-Protected Securities) in the US.
These bonds pay a guaranteed rate of return on top of inflation. However, this guaranteed rate is quite low. Bodie uses 2% as a long-term estimate. The attraction is that these bonds are very safe even from inflation.
Bodie uses the example of saving 100 kopecks per year for 40 years, and then withdrawing an inflation-adjusted 280 kopecks per year for 30 years of retirement. All this comes with no worries about stock returns or inflation.
This sounds appealing, but it’s worth looking a little closer. To save for 40 years before retiring at age 65 means saving starting at age 25. I’m all for starting to save for retirement early, but realistically, few people start saving serious amounts for retirement at age 25.
Instead of talking about kopecks, let’s try dollars. Let’s say that a 35-year old worker Wanda saves $5000 per year (after tax) in a Tax-Free Savings account (TFSA). We’ll assume that Wanda does this for 30 years and that the amount saved each year rises with inflation.
Wanda never touches this retirement money for 30 years and earns 2% above inflation each year. How much can she withdraw each year for 30 years starting age 65? The answer is an inflation-adjusted $9200 per year. If this doesn’t sound very good to you, then I agree. Between this and the Canada Pension Plan, Wanda probably has enough for rent and food, but not much else.
What if Wanda rolled the dice and invested in a mixture of stocks and bonds and earned average compound returns of 5% over inflation? In this case she’d be able to withdraw over $22,000 per year for 30 years.
Of course there is no guarantee that anyone would average 5% over inflation. Wanda might instead have better or worse returns. To avoid this risk, she could just resign herself to the guaranteed $9200 per year, but this isn’t very appealing either.
The truth is that most people won’t manage to save even $5000 after tax each year for their retirement. They are faced with the choice of a guaranteed pittance each year during retirement using Bodie’s plan, or rolling the dice with riskier investments. My personal choice is to roll the dice.